Speech
Financial Deregulation and Financial Markets

Introduction

It is difficult to talk about financial deregulation without rehashing Australian
events in the mid to late 1980s. I will try to keep this to a minimum, having
already had three goes at it in 1989, 1990 and 1991. Instead, I propose to
look at two quite separate subjects: first, the Australian experience in an
international context; and second, the influence of international financial
markets on domestic policy making.

The Transition Period

Before getting onto the two main topics, a little bit of clarification about what
we mean by financial deregulation is in order. Broadly speaking, there were
two major aspects of financial deregulation. The first aspect was macroeconomic,
and the major policies were the floating of the exchange rate (with associated
abolition of exchange controls), and the full implementation of the tender
system for selling debt to the public so that the budget deficit was financed
at market rates. To the best of my knowledge, these policies have produced
little or no public criticism, other than the charge that they give international
markets too much influence (a subject to which I will return).

The second aspect of financial deregulation was directed at financial intermediaries,
mainly banks, with a view to increasing competition. The major policy changes
were the abolition of both interest rate controls and credit guidelines, and
the entry of foreign banks. It is this aspect of financial deregulation that
has received the most criticism. There is a widespread belief that it contributed
to a surge in credit and to a boom and bust in asset prices, which added to
the economic cycle in Australia at this time.

It is possible to accept that there is a significant element of truth in this assertion,
while still remaining in favour of financial deregulation. In other words,
it is reasonable to maintain that a deregulated financial system is superior
to a regulated one, as I would, and yet concede that serious difficulties were
encountered in the transition process. The superiority of a deregulated system
is a view that is held most strongly by those who can still remember the difficulty
of trying to get the old regulated system to function in a world that was increasingly
economically integrated and where innovation could outpace regulation.

Why is it then that the transition difficulties of moving to a more competitive banking
system were under-estimated? I will provide two answers, but there may be more.

Economists are trained to describe the characteristics of a system in equilibrium
or at least in a reasonably settled state; they can even say that one system
is ‘better’ than another. What they are not good at is analysing
a regime shift – that is the process whereby one system
is replaced by another. This involves an intervening period during which market
participants, who have only ever played by one set of rules, are asked to
play by another set, and for high stakes. During this time, the consequences
of some types of apparently profitable behaviour are not known to the majority
of participants. As one prominent Australian banker is reported to have said
in the late 1980s, ‘I've had thirty-two years' experience, but
the first thirty were all the same.’

While people with really long memories might have been able to go back to the 1890s
or the 1920s to find instruction, most people rely on recent examples from
at home or abroad. Unfortunately, there was little relevant recent experience
in Australia, and overseas examples were not much help. This is because the
Australian asset price boom and bust was relatively early in the international
cycle. We had not seen in 1989 and 1990 just how widespread the boom and bust
of asset prices would be among OECD countries and hence could not learn from
them until it was too late. For example, it is now clear that the extreme
case of asset price boom and bust was in the Nordic countries, particularly
Finland and Sweden – but this was not fully played out until about 1992,
when we saw the collapse of the banking system in these countries.[1]
Similarly, the collapse of the bubble economy in Japan did not get going until about
1991.

As well as not learning from other countries in time, a lot of commentators on financial
deregulation have still not made the effort of putting the Australian experience
into international perspective. For example, there is still a perception that
the boom and bust in asset prices in Australia was exceptionally large by international
standards. My next section aims to dispel this misconception.

The International Experience

The best summary of these international developments is contained in the 1993 Annual
Report of the Bank for International Settlements (BIS), and a subsequent research
paper by Borio et al. (1994).[2]
These both have the great advantage of being written with the benefit of hindsight
and so they are able to survey the international scene from a vantage point
not available to Australian observers even a few years earlier.

Because the BIS economists were mainly interested in the growth of credit and asset
prices, they constructed asset price indices for OECD countries from 1970 using
the same methodology as we at the RBA had employed in our earlier work. That
is, they built up the aggregate index for each country from price indices for
shares, residential property and commercial property. This was a pretty ambitious
task, and the indices are only approximations of the broad trends over 20 years.
Nevertheless, they felt they were able to draw some clear conclusions. Let
me quote:

Asset prices have played a prominent role in the (recent world) business cycle, both
in terms of the amplitude of their fluctuations and because of their impact
on financial institutions and economic activity. Such medium-term swings are,
of course, not new; the last similar episode took place in the early 1970s.
What has drawn attention to the recent asset price movements is not only their
absolute size and geographical compass, it is also the fact that the prolonged
upswing, in contrast to the previous one, occurred
against a background of positive inflation-adjusted
interest rates.’ (italics added)

In other words, there may have been large rises and subsequent falls in some asset
prices in the 1970s, but that is only to be expected in a period of accelerating
inflation and where real interest rates were low or negative. In the 1980s,
however, there was asset price inflation in most countries even though general
inflation was decelerating and real interest rates were high. This was a conjunction
that no-one had experienced.

When turning to the experience of individual countries, they comment:

While a large number of countries experienced a cycle in real aggregate asset
prices over the last 10 years, the severity of asset price inflation and deflation
varied widely. The sharpest movements occurred in some of the Nordic countries
and in Japan.

The BIS survey of asset price rises puts Australia in the middle of the field. The
increase in Australian asset prices between 1982 and 1989 was 155 per cent
in nominal terms and 59 per cent in real terms (consumer prices rose by 60
per cent, or 7 per cent per annum). This sounds like a lot, and I do not wish
to suggest that it was otherwise. However, a number of other countries had
much more pronounced asset price booms (and busts). The summary table below
gives some figures.

Table 1: Increase in Real Asset Prices

Country

Cumulative percentage change

Period covered

Finland

191

1978 – 1988

Japan

164

1977 – 1989

Sweden

114

1980 – 1989

United Kingdom

102

1981 – 1989

Norway

73

1980 – 1989

Australia

59

1982 – 1989

Canada

52

1984 – 1989

Germany

39

1987 – 1991

United States

37

1981 – 1989

Source: Borio et al. (1994)

While we could quibble with some of these numbers – for example, the United
States looks surprisingly low – it is hard to see how the results for
some of the high-fliers could be altered greatly by measurement approximations.

The BIS makes several attempts to explain the growth in asset prices by the growth
of output, inflation and interest rates without much success. In the end, their
analysis leads them to the crucial role played by credit.

‘To a large extent, this rapid growth (in asset prices) reflected a relaxation of credit constraints
in the financial industry in the wake
of both market-driven and policy-determined structural changes. The end result
of those changes was greatly to increase competitive pressures in the industry
and to broaden the range of borrowing opportunities. In the process, they also
heightened the impact of
pre-existing tax provisions which encouraged
indebtedness and which had been less effective during the period when credit
rationing was prevalent.’ (italics added)

In other words, every country seemed to have an asset price boom of some sort in
the 1980s, and ours was not exceptional by international standards. Also, each
of these booms was associated with a relaxation of credit constraints, although
not all of them could be attributed directly to a sudden financial deregulation.
Certainly the Nordic countries were in that category, but Japan made only limited
and gradual steps towards deregulation. This suggests that international competitive
pressures swept a number of countries along even though policy makers were
reluctant to deregulate.

The Influence of Financial Markets

The papers in this conference all key off an admirably even-handed paper by Fred
Argy.[3]
While Fred is prepared to give credit to financial deregulation for improving microeconomic
efficiency, he feels that it has had the unintended effect of giving international
financial markets too much power over domestic economic policy. I won't
quote Fred in detail, but he says in various places that governments take a
long-term view, but markets are prone to short-termism; that markets are prone
to error because of their inability to fully read the policy intent and resolve
of the authorities; and that they unduly penalise governments pursuing social
and environmental priorities.

It is worth spending a bit of time on this subject because, while I understand some
of Fred's frustration with financial markets, in the end I come to the
opposite view. I believe that, over time, markets play a useful role in helping
countries put in place sustainable macro-economic policies in the face of some
quite powerful forces pushing in the opposite direction.

I am prepared to concede that in all markets where prices are freely determined,
their movements often seem illogical, even after the event. Medium-term movements,
whose direction is based on fundamentals, often go too far, i.e. overshoot,
and there are often short-term over-reactions to pieces of news. There is now
a burgeoning literature on bubbles, overshoots, positive feedback, etc., rather
than the general agreement on the Efficient Markets Hypothesis that characterised
the economic literature a decade ago. But these distortions are essentially
short run, and can justify a country ignoring market pressures for a time.
There is no reason, however, to believe that market pressures could systematically
cause a country to run bad policies or to eschew good policies in the long
run – that is, over a run of years or a decade.

International investors, whether they are based in Australia or abroad and whether
they are using their own money or managing funds for clients, aim for high
returns, and try to avoid losses. This latter aversion makes them reluctant
to invest in countries – whether it is their own or a foreign one –
whose policies are likely to lead to their investments losing value. In particular,
they are wary of countries whose fiscal policies result in large budget deficits
and whose monetary policies result in high inflation and a weak currency. Provided
it is based on facts, I cannot see why this behaviour on the part of international
investors is a bad thing, even viewed exclusively from the perspective of maximising
economic growth and social equity. When did large budget deficits and high
inflation ever help to attain either of those two worthy objectives?

The greatest contribution that macro-economic policy can make to those objectives
is to stay on a sustainable path. The biggest setbacks to growth and employment
do not occur in the normal year-to-year adjustment of policy – they occur
when governments are forced to tighten fiscal and monetary policy sharply to
retrieve an untenable external position or bring back a rate of inflation that
has got away. International markets can, and often do, provide the discipline
that helps domestic policy makers avoid the trap of letting macro-economic
policies slip into the unsustainable zone. Fred talks sympathetically of Sweden
because of the harsh treatment they have received from the markets. We must
remember that Sweden allowed a situation to develop where they had a budget
deficit equivalent to 13 per cent of GDP and a rate of inflation of 10 per
cent. I suspect that there are a lot of Swedes who wish their system had allowed
the market to exert pressure a lot earlier in the piece, so they could have
avoided this unsustainable policy predicament and its painful rectification.

It is not very illuminating to see the policy formulation process as a conflict between
only two parties – the government and the markets. What we are dealing
with is a government trying to put together coherent macro-economic policies
in the face of pressures from numerous interest groups. A minimal list would
include various industry groupings, such as manufacturers, exporters and farmers,
trade unions, social welfare groups, other single-interest pressure groups,
the press, and various lobby groups, not to mention backbenchers in marginal
seats. Looking down this list, it is clear that hardly any of these ever speak
out in favour of the difficult, but often necessary, tasks of cutting expenditure,
raising taxes or raising interest rates. Financial markets represent another
type of pressure group that acts as a counterweight to the list above. If someone
was to find a way of eliminating the bias of financial markets, I would be
more reassured if they could also do something about the bias inherent in the
demands of domestic pressure groups. This would, of course, be impossible,
so it is better to have the two countervailing sets of pressure in operation.

It is part of the story that is played out in all liberal democracies – the
difficulty of reconciling medium-term policy needs with the individual policy
changes that affect sectional interests. Often the sectional interests win,
and some observers see this as a win for democracy, but is it? We have just
seen the US Republicans win by a landslide in the November Congressional elections
on a platform that included a balanced budget as a major plank. By March they
had to admit defeat on this policy; they could not get the sectional interests
to make the changes necessary to achieve an outcome that a few months earlier
had been endorsed at the ballot box.

The influence of financial markets is not going to solve these problems at a stroke,
but they can at times make a useful contribution. For example, one of the most
successful pieces of Australian medium-term macro-economic policy making in
recent memory, from which we are still benefiting, was the achievement of a
budget surplus in the four years from 1987/88 to 1990/91. It is always difficult
to turn an adverse budgetary position around, and many countries have failed
to do so. Australia's success on this occasion was helped by the pressure
exerted by financial markets; it made it easier to bite the bullet and override
sectional pressures in the national interest.

To this point, I have only mentioned financial markets' distaste for large budget
deficits and inflation – I have not discussed current account deficits.
The reason is that for every complaint about markets being tough on countries
with large current account deficits, we have the opposite complaint that markets
are too tolerant of such deficits and too willing to finance them. Perhaps
this is because current account deficits are not always a bad thing, as Fred
noted, whereas a large entrenched budget deficit and high inflation always
are. Perhaps it is also because current account positions are a zero sum game;
for every surplus country, there has to be a deficit one. Whatever the reason,
it is hard to argue that markets prevent a country with a defensible reason
for having a current account deficit from continuing to do so. Thailand would
be a good example of this. On the other hand, when they judge that a current
account is getting too large, or being used to support consumption, then they
usually bring some pressure to bear via the exchange rate or interest rates.
In this respect, Australia is not in a strong position to argue that, over
the past decade, financial markets have treated it unfairly.

Conclusion

Most of the complaints in Australia about financial deregulation concerned events
that happened in the transition period between the old regime and the new.
We should concede that in this phase there were unforeseen consequences in
the form of an asset price boom and bust. We were not alone, however, in having
this experience during the late 1980s, and contrary to popular conception,
our experience does not stand out as being extreme by the standards of OECD
countries.

On the issue of whether deregulated financial markets contribute to good macro-economic
policy or not, I come down strongly in the affirmative. We can all find fault
from time to time with aspects of market behaviour, but we would find more
fault with the alternative ways of allocating capital, if we had to look at
them closely. Like democracy – which Churchill characterised as ‘the
worst form of government, except all those other forms that have been tried
from time to time’ – the market is the least bad way of allocating
capital.

Endnotes

It is estimated that the volume of official operations used to support the banking
systems in Norway, Sweden and Finland up to 1993 amounted to 3.1 per cent,
4.7 per cent and 7.3 per cent of GNP respectively. See Bank for International
Settlements (1993), 63rd Annual Report, Basle.
[1]